Thursday, 15 December 2016

Cost benefit of demonetisation Part II

                               CBA of impact of demonetisation on the economy

CBA is more reliable and widely used where costs as well as benefits can be quantified realistically.

Can the technique be applied to demonetisation? CBA of demonetisation is not as simple as CBA of an investment project. For an investment project, it is possible to identify and quantify direct as well as indirect costs and benefits and to compare the two situations: ‘with’ (i.e. with investment in the project) and ‘without’ (i.e. without investment in the project) to get an idea of gain or loss that can be attributed to the project. In the case of demonetisation, ex-ante quantification of cost is based on broad generalisations. Reliable number would be available only after nationwide statistics are collected and analysed. Moreover, even if loss to the economy (i.e. fall in GDP) is quantified, it is almost impossible to quantify subsequent gains which could be attributed exclusively to demonetisation.

Let us first see what experts have said so far.

The supporters as well as opponents are unanimous that demonetisation has slowed down economic growth, though they differ on its duration and magnitude. There are differences about benefits also, not just in the short and medium terms but even in long terms. The Government of India believes that short-term pain will be more than compensated by gains in long-term; apart from flushing out black money and counterfeit notes, more gains will come through digitisation of transactions for which more facilities and incentives are being provided; revenue collection will go up and decline in corruption and terrorist activities will also boost growth rate. On the other hand, critics say that any benefit will be offset by disastrous effect on the poor. Mocking at the claim of long-term benefit, in a speech in the Rajya Sabha, Dr Manmohan Singh quoted the famous economist JM Keynes that ‘in the long run we are all dead.’ It is a typical reaction of theoretical economists like Dr Singh when cornered. Keynes himself is famous for suggesting short-term measure – increased money supply to improve purchasing power to revive idle productive capacity – for quick economic recovery. Dr Singh knows very well that Prime Minister is talking of gain starting from the end of the short period of transition. In his book The Curse of Cash, famous Harvard economist Kenneth Rogoff has favoured demonetisation of high currency notes to curb black money and expects similar benefit in India but only in the short term because in his opinion most of the illicit economic activities take place in high currency notes and India has introduced new currency notes of ₹2000.

Different experts have given different estimates of decline in growth rate on account of demonetisation. At the beginning of the current fiscal, the Central Government  had set the target of 8% growth in GDP. As against that, it was only 7.1% in the first quarter of 2016-17 and 7.3%  in the second quarter. The RBI’s latest estimate (on account of demonetisation) is 7.1%, as against the earlier (before demonetisation) estimate of 7.6%. The other estimates are: Morgan Stanley - 7.3% in 2016-17; CRISIL: 6.9%, Fitch - 6.9% in 2016-17 and 7.7% next year. Deutsche Bank - 6.5% in 2016-17 and 7.5% in 2017-18; Goldman Sachs - 6.4%; Ambit Capital -3.5% in 2016-17 and 5.8% next year;   economist Montek Ahluwalia - 6%; Dr Manmohan Singh - fall by two percentage points; economist Surjit Singh Bhalla - fall of only one percentage point (because of better performance of the agricultural sector); Centre for Monitoring of Indian Economy - loss of ₹1.28 lakh cr.

Initially many experts claimed that to the extent cash did not return to banks, there would be windfall to the government because the RBI would return equivalent amount of cash to the government as special dividend. The RBI has clarified such amount will be reflected only in its balance sheet, not in income statement.  However, to that extent government’s debt to the RBI will be reduced and government may raise fresh debt.

How much cash will come back to the banking system has also become controversial. So far high-value currency notes worth Rs 11.55 lakh crore have come , though the State Bank of India (SBI) has doubts about the RBI’s estimates. According to the SBI, there are possibilities of double counting because of inter-bank transfers and deposit of new currency notes. About a week back the SBI had estimated that at the ultimately about ₹2.5 lakh cr. would not return to the banking system. That estimate has been completely demolished by Revenue Secretary Hasmukh Adhia who has said that the government expected all the monetised money to come back to the banking system. Being Revenue Secretary, Adhia is supposed to know everything about taxation and black money. Maybe, he has knowledge that the amount which experts expected to remain unreturned will be declared under the new income tax disclosure scheme provided in the recent amendment to the Income Tax Act. If the entire cash in circulation on November 8 returns to the banking system, then all the rumours about politicians and others hoarding hard currencies in gunny bags will prove false or would mean that they succeeded in moving all their cash to banks. In either case, Prime Minister Modi will have to face attacks from his political opponents as well as economists and financial experts.

Whether Revenue Secretary’s expectations prove true or false would be known only when the time limit for deposit is over. However, with lakhs of legal windows kept open by the government (it amounts to ‘demonetisation in phases’) and lakhs of illegal channels provided by corrupt bankers, charitable trusts, NGOs, priests of temples and commission agents, besides Jan-Dhan account holders, the chances of return of most, if not all, of the black cash have increased.

Collection of direct taxes is expected to improve. Economist Bhalla’s estimate is ₹2.5 lakh crore in the current year and ₹1.5 lakh crore per annum thereafter. Revenue Secretary’s expectation that after the return of entire demonetised money to the banking system, income tax authorities will segregate ‘black’ from ‘white’ and will collect tax and penalty does not augur very well, either for the officers of the IT Department or for the government treasury. There will be unprecedented workload on the limited resources of the Department. Additions to declared income will lead to prolonged litigation and good part of disputed tax will remain blocked.

In the absence of data for CBA in the conventional sense, I have adopted a different approach. I have first considered cost in form of loss of GDP and then carried out a set of sensitivity analyses to estimate growth rate required to recover the loss and then to achieve significant improvement in the economy.

Assumptions and methodology for evaluation of impact

(a) Numeraire (accounting unit) is GDP measured in Indian rupees at 2015-16 prices.  GDP captures results of all economic activities: monetary value of all goods and services produced when measured by output method, total expenditure incurred by all entities on goods and services when measured by expenditure method and total income earned by the factors of production when measured by income method.

(b) Cost to the economy on account of demonetisation is loss of GDP  calculated with reference to the GDP expected in 2016-17 without demonetisation. Benefit is increase in GDP when the economy picks up in later years more resources are available for investment, though it would not be realistic to attribute entire incremental benefit to the after-effects of demonetisation. ((It is not correct to deduct loss of GDP from additional revenue to arrive at loss or gain attributed to demonetisation. These are two different numeraires).

(c) 7.6% has been assumed to be the growth rate in 2016-17 without demonetisation.  In 2015-16, India’s GDP (at current prices) was Rs. 135.76 lakh cr. At 7.6% growth rate, GDP for 2016-17 works out Rs. 146.08 lakh cr. without demonetisation and Rs. 145.40 with demonetisation (at 2015-16 prices). Thus, going by the RBI estimate, demonetisation would result in loss of  Rs. 0.68 lakh crore only.

 (d) Since fall in GDP in the current year and/or next year is still an estimate and different experts have given different estimates which may be quite different from the actual number available later, sensitivity analyses have been carried out assuming different rates of decline. Similarly sensitivity analyses have been carried out assuming different rates of growth of GDP in later years.

(e) Discount rate is 6.5% which is the close to 10-Year Government Securities Yield (6.51% of November 18, 6.28% on November 25, 2016).

The results of analyses are summarised below. 

Assumption (Growth rate)
(No. of years required to recover loss (if GDP grows after initial years of fall) from the end of 2016-17

7.1% in 2016-17 (as estimated by RBI)
Loss in perpetuity
Less than 2 years

6.5% in 2016-17
Loss in perpetuity
Less than 3 years
Less than 2 years

5.5% in 2016- 17 
Loss in perpetuity
More than 5 years
More than 2 years
Less than 2 years
5.5% in 2016-17 and 6.5% in 2017-18 
Loss in perpetuity
More than 8 years 
More than 5 years 
More than 4 years

The assumptions about significant jump in growth may not be realistic but the sensitivity analyses give a broad idea of the challenges ahead. Unless post-2017 fiscal, growth rate is more than 8%, loss caused by demonetisation would not be compensated. Lower the growth rate in 2016-17, longer the time to make up the loss. In the worst scenario assumed – growth rate of 5.5% in 2016-17 and 6.5% in 2017-18 (if the set back to the economy persists) - even at 11% growth in subsequent years will not be sufficient to make up the loss by 2020-21.

Policy implications

The biggest challenge is to raise the growth rate substantially. The million dollar question is whether the challenge can be met. It may be difficult but is not impossible. Improvement in tax collection will enable the government to make more investment in infrastructure. Banks will have more funds for lending. More investment in creation of capital assets will generate more employment which will improve people’s purchasing power. However, availability of funds alone is not the only condition. The government, PSUs and private sector, all will need to be ready with viable and implementable projects. Implementation of projects depends not only on the availability of funds but also on the availability of land timely clearances and skilled manpower. Considering the mounting burden of the NPAs (non-performing assets), banks may not be liberal in sanctioning fresh loans. The private sector will definitely demand structural reforms like labour reforms, which is not an easy task in a democracy like India.

Reduction in terrorist and naxal activities – reportedly already hit hard by demonetisation – and in corruption should also improve growth rate. Moody's studies show that terrorist attacks cause decline in investment and cut growth of  GDP by 0.5 to 0.8 percentage points; the worst part is that the negative impact continues for years after attacks.

Widespread corruption in India is certainly affecting economic growth and purchasing power of the people. Management guru C. K. Prahalad’s estimates show that ‘the lost opportunity caused by corruption, in terms of investment, growth and jobs for India is over US$50 billion a year.’ According to the Transparency International,  corruption is rampant in welfare schemes such as MNREGA and National Rural Health Mission. Such corruptions drastically reduce purchasing power of the poor. Trucking industry has also been named as another major source of corruption because billions of rupees are paid in bribes to numerous regulatory authorities and police for smooth operation. Common people expect Prime Minister Modi to take stringent anti-corruption measures and to improve transparency in economic activities and public life. Reduction in political corruption due to reduced availability of cash for fighting elections should also lead to all-round reduction in corruption in the country.

Let us see how the challenges are met but no challenge can be met effectively without people’s cooperation. Right now, people are losing patience because of non-availability of cash from banks and ATMs while corrupt fellows are found hoarding new currency notes worth billions of rupees.

The bottom line is the growth rate will ultimately depend not just on better management of the economy but also on drastic check on corrupt practices. Prime Minister Modi has to prove his leadership.

Devendra Narain
(Former head of the Project Appraisal Division of the Planning Commission)
December 09, 2016

Link for Part I of Cost benefit analysis of demonetisation:

(In necessary, please copy and paste)

Another article worth reading: Who are sabotaging objectives of demonetisation?